Texas Capital Bancshares - 10-Q quarterly report FY

214/932-6600
(Registrant’s telephone number,
including area code)

N/A
(Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report)

     Indicate by checkmark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o

     Indicate by checkmark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer. See definition of “large accelerated filer” and “accelerated filer” Rule 12b-2 of the Exchange Act.

     Indicate by checkmark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ

     On July 31, 2006, the number of shares set forth below was outstanding with respect to each of the issuer’s classes of common stock:

Common Stock, par value $0.01 per share                       25,983,809

Index

The accounting and reporting policies of Texas Capital Bancshares, Inc. conform to accounting principles generally accepted in the United States and to generally accepted practices within the banking industry. Our Consolidated Financial Statements include the accounts of Texas Capital Bancshares, Inc. and its subsidiary, Texas Capital Bank, National Association (the “Bank”). Certain prior period balances have been reclassified to conform with the current period presentation.

The consolidated interim financial statements have been prepared without audit. Certain information and footnote disclosures presented in accordance with accounting principles generally accepted in the United States have been condensed or omitted. In the opinion of management, the interim financial statements include all normal and recurring adjustments and the disclosures made are adequate to make interim financial information not misleading. The consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q adopted by the Securities and Exchange Commission (SEC). Accordingly, the financial statements do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements and should be read in conjunction with our consolidated financial statements, and notes thereto, for the year ended December 31, 2005, included in our Annual Report on Form 10-K filed with the SEC on March 3, 2006 (the “2005 Form 10-K”).

On January 1, 2006, we changed our accounting policy related to stock-based compensation in connection with the adoption of Statement of Financial Accounting Standards (SFAS) No. 123, “Share-Based Payment (Revised 2004) (“SFAS 123R”). Prior to adoption, we accounted for stock plans under the recognition and measurement principles of APB Opinion 25, “Accounting for Stock Issued to Employees”, and related interpretations. No stock-based compensation was reflected in net income, as all option grants had an exercise price equal to the market value of the underlying common stock on the date of the grant. SFAS 123R eliminates the ability to account for stock-based compensation using APB 25 and requires that such transactions be recognized as compensation expense in the statement of operations based on their fair values on the measurement date, which is generally the date of the grant. We transitioned to fair value based accounting for stock-based compensation using a modified version of prospective application (“modified prospective application”). Under modified prospective application, as it is applicable to us, SFAS 123R applies to new awards and to awards modified, repurchased or cancelled after January 1, 2006. Additionally, compensation expense for the portion of awards for which the requisite period has not been rendered (generally referring to nonvested awards) that are outstanding as of January 1, 2006 will be recognized as the remaining requisite service is rendered during and after the period of adoption of SFAS 123R. The compensation expense for the earlier awards is based on the same method and on the same grant date fair values previously determined for the pro forma disclosures required for all companies that did not previously adopt the fair value accounting method for stock-based compensation.

The fair value of our stock option and stock appreciation right (SAR) grants are estimated at the date of grant using the Black-Scholes option pricing model. The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because our employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide the best single measure of the fair value of its employee stock options.

As a result of applying the provisions of SFAS 123R during the three and six months ended June 30, 2006, we recognized additional stock-based compensation expense of $695,000, or $458,000 net of tax, and $1.1

million, or $739,000 net of tax. The increase in stock-based compensation expense related to stock options resulted in a $0.02 decrease and a $0.03 decrease in diluted earnings per share during the three and six months ended June 30, 2006. The amount for the three months ended June 30, 2006 is comprised of $396,000 related to unvested options issued prior to the adoption of SFAS 123R, $210,000 related to SARs issued in the second quarter of 2006, and $89,000 related to RSUs issued in the second quarter of 2006. The amount for the six months ended June 30, 2006 is comprised of $795,000 related to unvested options issued prior to the adoption of SFAS 123R, $220,000 related to SARs issued in 2006, and $106,000 related to RSUs issued in 2006. Cash flows from financing activities for the six months ended June 30, 2006 included $2.3 million in cash inflows from excess tax benefits related to stock compensation. Such cash flows were previously reported as operating activities. Unrecognized stock-based compensation expense related to unvested options issued prior to adoption of SFAS 123R is $ 4.2 million, pre-tax. At June 30, 2006, the weighted average period over which this unrecognized expense is expected to be recognized was 2.1 years. Unrecognized stock-based compensation expense related to grants issued during 2006 is $5.8 million. At June 30, 2006, the weighted average period over which this unrecognized expense is expected to be recognized was 2.6 years.

The following pro forma information presents net income and earnings per share for the three and six months ended June 30, 2005 as if the fair value method of SFAS 123R had been used to measure compensation expense for stock-based compensation.

The following table presents the computation of basic and diluted earnings per share (dollars in thousands except per share data):

The Bank is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit which involve varying degrees of credit risk in excess of the amount recognized in the consolidated balance sheets. Our exposure to credit loss in the event of non-performance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amount of these instruments. We use the same credit policies in making commitments and conditional obligations as we do for on-balance sheet instruments. The amount of collateral obtained, if deemed necessary, is based on management’s credit evaluation of the borrower.

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments may expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Bank evaluates each customer’s credit-worthiness on a case-by-case basis.

Standby letters of credit are conditional commitments we issue to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers.

Statements and financial analysis contained in this document that are not historical facts are forward looking statements made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward looking statements describe our future plans, strategies and expectations and are based on certain assumptions. As a result, these forward looking statements involve substantial risks and uncertainties, many of which are beyond our control. The important factors that could cause actual results to differ materially from the forward looking statements include the following:

We have no obligation to update or revise any forward looking statements as a result of new information or future events. In light of these assumptions, risks and uncertainties, the events discussed in any forward looking statements in this quarterly report might not occur.

We recorded net income of $6.3 million, or $.24 per diluted common share, for the second quarter of 2006 compared to $6.6 million, or $.25 per diluted common share, for the second quarter of 2005. Return on average equity was 11.39% and return on average assets was .78% for the second quarter of 2006 compared to 13.14% and .97%, respectively, for the second quarter of 2005. The primary reason for the decline in return on equity and return on assets was related to the $2.25 million of loan loss provision in the second quarter of 2006.

Net interest income for the second quarter of 2006 increased by $6.6 million, or 27.1%, from $24.5 million to $31.1 million over the second quarter of 2005. The increase in net interest income was due to an increase in average earning assets of $507.5 million, or 19.8%, with a 22 basis point increase in net interest margin.

Non-interest income increased $2.2 million, or 46.1%, compared to the second quarter of 2005. The increase is primarily related to a $584,000 increase in insurance commission income from $172,000 to $756,000 due to increased focus on the insurance business. Rental income on leased equipment increased $814,000 related to expansion of our operating lease portfolio. Additionally, trust fee income increased $251,000 due to continued growth of trust assets, and gain on sale of loans increased $239,000.

Non-interest expense increased $6.9 million, or 36.1%, compared to the second quarter of 2005. The increase is primarily related to a $4.4 million increase in salaries and employee benefits to $16.3 million from $11.9 million. The increase in salaries and employee benefits resulted from increases in commissions and incentives for both residential lending and insurance lines of business, the total number of employees related to the addition of the premium finance business and general business growth. Net occupancy and equipment expense increased $1.3 million from $1.9 million to $3.2 million in the second quarter of 2006 relating to our general business growth, continued growth in the residential mortgage lending division and depreciation related to expansion of our operating lease portfolio.

Net interest income was $31.1 million for the second quarter of 2006, compared to $24.5 million for the second quarter of 2005. The increase was due to an increase in average earning assets of $507.5 million as compared to the second quarter of 2005 and a 22 basis point increase in net interest margin, reflecting rising market interest rates. The increase in average earning assets included a $604.9 million increase in average loans held for investment and an increase of $52.8 million in loans held for sale, offset by a $147.2 million decrease in average securities. For the quarter ended June 30, 2006, average net loans and securities represented 81% and 19%, respectively, of average earning assets compared to 71% and 29% in the same quarter of 2005.

Average interest bearing liabilities increased $449.0 million from the second quarter of 2005, which included a $511.7 million increase in interest bearing deposits offset by a $106.7 million decrease in other borrowings. The average cost of interest bearing liabilities increased from 2.78% for the quarter ended June 30, 2005 to 4.50% for the same period of 2006, reflecting rising market interest rates and change in funding mix.

Net interest income was $59.8 million for the first six months of 2006, compared to $46.2 million for the same period of 2005. The increase was due to an increase in average earning assets of $458.5 million as compared to 2005 and a 36 basis point increase in net interest margin. The increase in average earning assets included a $591.6 million increase in average loans held for investment and an increase of $36.5 million in loans held for sale, offset by a $154.7 million decrease in average securities. For the six months ended June 30, 2006, average net loans and securities represented 80% and 20%, respectively, of average earning assets compared to 70% and 30% in the same period of 2005.

Average interest bearing liabilities increased $400.2 million compared to the first six months of 2005, which included a $495.5 million increase in interest bearing deposits offset by a $130.2 million decrease in other borrowings. The average cost of interest bearing liabilities increased from 2.64% for the six months ended June 30, 2005 to 4.30% for the same period of 2006, reflecting the rising market interest rates and change in funding mix.

TABLE 1 — VOLUME/RATE ANALYSIS
(In thousands)

Net interest margin, the ratio of net interest income to average earning assets, was 4.10% for the second quarter of 2006 compared to 3.88% for the second quarter of 2005. The improvement in net interest margin resulted primarily from a 169 basis point increase in the yield on earning assets while interest expense as a percentage of earning assets increased by only 146 basis points.

Non-interest income increased $2.2 million compared to the same quarter of 2005. The increase is primarily related to a $584,000 increase in insurance commission income from $172,000 to $756,000 due to increased focus on the insurance business. Rental income on leased equipment increased $814,000 related to expansion of our operating lease portfolio. Additionally, trust fee income increased $251,000 due to continued growth of trust assets, and gain on sale of loans increased $239,000.

Non-interest income increased $4.0 million during the six months ended June 30, 2006 to $12.9 million compared to $8.9 million during the same period of 2005. The increase is primarily related to a $1.2 million increase in insurance commission income from $285,000 to $1.5 million due to increased focus on the insurance business. Rental income on leased equipment increased $1.3 million related to expansion of our operating lease portfolio. Additionally, trust fee income increased $508,000 due to continued growth of trust assets, and brokered loan fees increased $234,000.

While management expects continued growth in non-interest income, the future rate of growth could be affected by increased competition from nationwide and regional financial institutions. In order to achieve continued growth in non-interest income, we may need to introduce new products or enter into new markets. Any new product introduction or new market entry would likely place additional demands on capital and managerial resources.

TABLE 2 — NON-INTEREST INCOME
(In thousands)

Non-interest expense for the second quarter of 2006 increased $6.9 million, or 36%, to $26.1 million from $19.2 million, and is primarily related to a $4.4 million increase in salaries and employee benefits to $16.3 million from $11.9 million. The increase in salaries and employee benefits resulted from increases in commissions and incentives for both residential lending and insurance lines of business, the total number of employees related to the addition of the premium finance business, general business growth and increased compensation, including adoption of SFAS 123R, reflective of our performance. Of the increase, approximately $65,000 is related to commissions in the residential mortgage lending division and represents a variable component of compensation expense directly related to residential loan production, sales and gains on the sale of mortgage loans reflected in non-interest income. As a result of adopting the provisions of SFAS 123R, we recognized additional stock-based compensation of $695,000 during the three months ended June 30, 2006 as compared to the same period in 2005.

Net occupancy and equipment expense for the three months ended June 30, 2006 increased by $1.3 million, or 68.0%, compared to the same quarter in 2005 relating to our general business growth, continued growth in the residential mortgage lending division and depreciation related to expansion of our operating lease portfolio.

Marketing expense increased $68,000, or 7%. Marketing expense for the three months ended June 30, 2006 included $115,000 of direct marketing and promotions and $602,000 for business development compared to direct marketing and promotions of $160,000 and business development of $440,000 during the same period for 2005. Marketing expense for the three months ended June 30, 2006 also included $273,000 for the purchase of miles related to the American Airlines AAdvantage^® program compared to $322,000 for the same period for 2005. Our direct marketing may increase as we seek to further develop our brand, reach more of our target customers and expand in our target markets.

Legal and professional expense for the three months ended June 30, 2006 increased $268,000, or 24% compared to the same quarter in 2005 mainly related to growth and increased cost of compliance with laws and regulations.

Non-interest expense for the first six months of 2006 increased $13.8 million, or 37%, to $50.8 million from $37.0 million during the same period in 2005. This increase is primarily related to an $8.4 million increase in salaries and employee benefits to $31.8 million from $23.4 million. The increase in salaries and employee benefits resulted from increases in commissions and incentives for both residential lending and insurance lines of business, the total number of employees related to the addition of the premium finance business, general business growth and increased compensation, including adoption of SFAS 123R, reflective of our performance. Of the increase, approximately $323,000 is related to commissions in the residential mortgage lending division and represents a variable component of compensation expense directly related to residential loan production, sales and gains on the sale of mortgage loans reflected in non-interest income. As a result of adopting the provisions of SFAS 123R, we recognized additional stock-based compensation of $1.1 million during the six months ended June 30, 2006 as compared to the same period in 2005.

Net occupancy expense for the six months ended June 30, 2006 increased by $2.3 million, or 66%, compared to the same period in 2005 relating to our general business growth, continued growth in the residential mortgage lending division and depreciation related to expansion of our operating lease portfolio.

Marketing expense increased $177,000, or 11%, compared to the first six months of 2005. Marketing expense for the six months ended June 30, 2006 included $259,000 of direct marketing and promotions and $962,000 for business development compared to direct marketing and promotions of $223,000 and business development of $762,000 during the same period for 2005. Marketing expense for the six months ended June 30, 2006 also included $577,000 for the purchase of miles related to the American Airlines AAdvantage^® program, compared to $636,000 for the same period for 2005. Our direct marketing expense may increase as we seek to further develop our brand, reach more of our target customers and expand in our target markets.

Legal and professional expense for the six months ended June 30, 2006 increased $639,000, or 29%, compared to the same period in 2005 mainly related to growth and increased cost of compliance with laws and regulations.

TABLE 3 — NON-INTEREST EXPENSE
(In thousands)

The aggregate loan portfolio at June 30, 2006 increased $398.5 million from December 31, 2005 to $2.6 billion. Commercial loans increased $214.7 million and real estate loans increased $46.1 million. Construction loans, loans held for sale, and leases increased $77.6 million, $53.3 million and $8.9 million, respectively. Consumer loans decreased $2.1 million.

TABLE 4 — LOANS
(In thousands)

We continue to lend primarily in Texas. As of June 30, 2006, a substantial majority of the principal amount of the loans in our portfolio was to businesses and individuals in Texas. This geographic concentration subjects the loan portfolio to the general economic conditions within this area. We originate substantially all of the

loans in our portfolio, except in certain instances we have purchased individual leases and loan and lease pools (primarily commercial and industrial equipment and vehicles), as well as selected loan participations and USDA government guaranteed loans.

The reserve for loan losses, which is available to absorb losses inherent in the loan portfolio, totaled $19.6 million at June 30, 2006, $18.9 million at December 31, 2005 and $18.8 million at June 30, 2005. This represents 0.81%, 0.91% and 1.04% of loans held for investment (net of unearned income) at June 30, 2006, December 31, 2005 and June 30, 2005, respectively.

The provision for loan losses is a charge to earnings to maintain the reserve for loan losses at a level consistent with management’s assessment of the loan portfolio in light of current economic conditions and market trends. Due to the combined effects of loan growth and the increase in loan charge-offs as compared to prior quarters, we recorded a $2.25 million provision for loan losses during the second quarter of 2006 compared to no provision in the second quarter of 2005 and the first quarter of 2006.

The reserve for loan losses is comprised of specific reserves for impaired loans and an estimate of losses inherent in the portfolio at the balance sheet date, but not yet identified with specified loans. We regularly evaluate our reserve for loan losses to maintain an adequate level to absorb estimated loan losses inherent in the loan portfolio. Factors contributing to the determination of specific reserves include the credit worthiness of the borrower, changes in the value of pledged collateral, and general economic conditions. All loan commitments rated substandard or worse and greater than $1,000,000 are specifically reviewed and a specific allocation is assigned based on the losses expected to be realized from those loans. For purposes of determining the general reserve, the portfolio is segregated by product types to recognize differing risk profiles among categories, and then further segregated by credit grades. Credit grades are assigned to all loans greater than $50,000. Each credit grade is assigned a risk factor, or reserve allocation percentage. These risk factors are multiplied by the outstanding principal balance and risk-weighted by product type to calculate the required reserve. A similar process is employed to calculate that portion of the required reserve assigned to unfunded loan commitments.

The reserve allocation percentages assigned to each credit grade have been developed based on an analysis of our historical loss rates and historical loss rates at selected peer banks, adjusted for certain qualitative factors. Qualitative adjustments for such things as general economic conditions, changes in credit policies and lending standards, and changes in the trend and severity of problem loans, can cause the estimation of future losses to differ from past experience. The unallocated portion of the general reserve serves to compensate for additional areas of uncertainty and considers industry trends. In addition, the reserve considers the results of reviews performed by independent third party reviewers as reflected in their confirmations of assigned credit grades within the portfolio. The allowance, which has declined as a percent of total loans, is considered adequate and appropriate, given the significant growth in the loan and lease portfolio, current economic conditions in our market areas and other factors.

The methodology used in the periodic review of reserve adequacy, which is performed at least quarterly, is designed to be dynamic and responsive to changes in portfolio credit quality and anticipated future credit losses. The changes are reflected in the general reserve and in specific reserves as the collectibility of larger classified loans is evaluated with new information. As our portfolio matures, historical loss ratios have been closely monitored, and our reserve adequacy relies primarily on our loss history. Currently, the review of reserve adequacy is performed by executive management and presented to our board of directors for their review, consideration and ratification on a quarterly basis.